Thursday, July 17, 2008

What Is Going On In The World Economy?

I had planned to write a long and detailed essay on this subject, but have recently been pressed for time. As such I am hoping that I will be forgiven writing a brief introduction to such a large topic. I am afraid that the introduction will lack references and specifics, for which I will apologise in advance.

The starting point for my explanation is where the world economy is now. As just about everyone will be noting, there is a housing crash in progress, a rapid decline in consumer spending, and retail price inflation in the UK and USA. Europe is also sinking into troubles, as are New Zealand and Canada. Australia remains a bright spot.

In short, most of the Western economies are falling off a cliff. In my essay 'A Funny View of Wealth' I detail how this situation has arisen in a fairly mechanistic way. What I do not cover is the real roots of the current problems.

However, in one post, I do make a start. The post in question is the 'Cigarette Lighter Problem'. I will do my best to summarise this. Basically the post asks the question of why it is that an identical cigarette lighter, delivered through near identical distribution systems, to near identical shops, with identical levels of service, can cost 9 times more in a Western country than China? Where is the added value to justify such a differential? If we think about it, there is no justification. The underlying difference is that the West is just more expensive. From this we can then ask a difficult question; why?

It is here that we come to the problem. In order for us to support such a high cost of living it means that some part of the economy will need to be creating huge added value, generating massive amounts of wealth. Although the cigarette lighter is one case, there are many, many other cases that are the same. Where is all this wealth that is being distributed through the economy coming from? Where are these fantastic wealth producers?

As soon as we ask this question, we can start to survey the economies of the Western World, as I did for the UK in 'A Funny View of Wealth', and find that there is no sector that is producing this apparently prodigious wealth. Sure, in all of the Western countries, there are some very good wealth producing companies, but the trouble is that, if you look at the figures, you find that countries such as the UK have not, for example, been increasing manufacturing output, or exporting enough services to explain growth. Even more troubling is if we make the comparison between China and the UK, for example, and ask what hugely wealth creating businesses that the UK has, that China does not? Increasingly the two countries (at least if we look at Chinese cities) have similar infrastructure, similar levels of services, similar levels of technology and so forth. So how is it that our lighter can cost so much in the UK compared with China?

In other words, where can the huge competitive advantage be found in the UK economy?

It is at this point that there may be possible to hear mutterings about a 'better educated workforce', and similar arguments. However, this is not a good of itself, and is increasingly questionable. Having worked in the Chinese university system, I was involved in preparing Chinese students for studying for post-graduate degrees in Western countries. The students the Western universities were accepting were being rejected from Chinese universities.

Another example given as a justification is technological superiority. The people who make such assertions are probably not aware that such technologies and processes are being exported wholesale to China, as Western countries have sought to gain competitive advantage from lower labour and operating costs. Only the most sensitive technologies and processes are prevented from being exported. In any case the complete disrespect shown by Chinese companies for intellectual property rights, renders many defences against export meaningless, in particular in a world where intellectual property is so rapidly and seamlessly transported.

A year ago, the might of the Western banking system may also have been given as an example of advantage, but with sovereign wealth funds bailing out Western banks, few would suggest such an idea now.

So where is the advantage? How is it that the Western economies are generating enough wealth to support the cost of a lighter being 9 times higher? If we look for the source of wealth, it is not possible to come up with anything substantive.

So what has been happening in the world economy? Over the last ten to twenty years, it appeared as if an economic miracle was taking place. Sustained growth, low inflation, and increased wealth.

But is that what was going on? I have argued that this is not the case in 'A Funny View of Wealth' so will not rehash the arguments here. The important point is that something dramatic has occurred in the world economy. For the moment I will focus on China, as that is the country I know most about.

In the case of China, it opened to the West following the reforms of Deng Xiaoping and, from a modest start, saw an accelerating pace of growth, albeit starting from a low base. The momentum of that growth only started to be felt in the late 90s. At that time, for consumer goods, the whole Chinese economy (if I remember correctly it was a person from Nestle who I spoke with) was of similar size for consumer goods as Germany. Although there had been excitement about China before this, it was only at this point that everybody started to take notice, and that the pace of growth really represented a major shift in the world economy.

So what was happening when China opened up. The extraordinary thing that occurred was actually the conjunction of two vitally important processes. The first of these was the introduction of a massive source of labour into the world market, in this case nearly a billion new units of labour (and no, they were not all poorly educated, as even in the late 90s China was churning out large numbers of university graduates). Now this, of itself, was not important. There had always been large sources of cheap and untapped labour around the world, but most of the labour remained under utilised. What made the real difference with China, was the massive investment and technology transfers that were taking place from West to East.

China emerged onto the world market with a government that was uniquely business oriented (at least by the 90s), with their legitimacy built upon the foundations of ongoing economic growth. To facilitate such growth they built infrastructure, and a framework that told the Western businesses that it was a safe bet to invest in China for the long term. The result was a flood of foreign direct investment, and a flood of technology and know-how into China.

It is at this point we come to something rather special about China, and that is Chinese culture. The miracle in China was that Mao ever managed to pull off the communist revolution. I will not to into history here (even though I have a passion for modern Chinese history), to explain how it happened. The important point I would like to make is that there is something in Chinese culture which seems to make them (in general) naturally good businesspeople. If you visit Vietnam, Malaysia, Indonesia and so forth, you will find Chinese businesspeople at the top of the economy, despite their being minorities.

So what does this conjunction of factors add up to? The first point to make is that, in order for a massive supply of labour to be brought into a market, it takes more than just existence. In order for the labour to come into play, it requires the technology, capital, infrastructure and will. In the case of China, all of these elements came into play.

The result is that China had actually managed to bring a huge amount of labour effectively into the world market,. That process is still continuing, and still has substantial reserves still waiting to come into the market. This labour includes every level of skill and education.

Basic economics says that if supply increases, then prices will come down. We then have to ask what will happen when such a large pool of labour enters the world market? Will the price of labour go down? Well, of course it will........it is basic economics. What has made the real difference here is that the entry of this labour has been supported by an equalisation of capital and technology. All the Chinese had to do was learn how to do business, something for which they seem to have a cultural talent for. This has also occurred over the last twenty years.

Now if we accept this, how does this explain the current state of the world economy? The first thing to note is the balance of payments deficits of the West have been supported by capital accumulation in the East. This has seen a massive transfer of wealth from West to East. The East has continued to lend to the West on the basis that, like the West itself, it believed that the West was naturally more stable and a solid economic bet (sorry for the metonymy here, but it simplifies the expression of the ideas). As such the West has been going steadily further into debt, with both consumers and government borrowing like madmen. All the time both the lenders and borrowers were under the illusion that this situation was sustainable.

The result of all of this spending was an illusion in the Western world that nothing had changed. We had moved into the post-industrial service based economy. The share of manufacturing in the economy steadily declined and the economists all accepted this as a perfectly sustainable new economic order. The reality was that massive borrowing was just delaying the inevitable, the readjustment of the world economy to the massive input of productive labour. In delaying the impact of this adjustment, the imbalances have actually become far greater than they would otherwise have been. Even now, the West is still not prepared to take on the new competition of the emerging economies, in particular China. If anything, the West is in a far more grave situation than would have otherwise been the case. The massive debt that has been accumulated must now be repaid, and this at a time when the West desperately needs capital to invest in rebuilding collapsing economies.

The best way to explain this is through a 'what if' scenario. Let's imagine that Western governments had become alarmed at the balance of payments deficits, and that they had realised that something must be done. Instead of encouraging the credit boom, and boom in government deficits, the government had sought to face the challenge of new competition. The logical policy would have been to address the cost base of their businesses, as well as the cost base of government. Furthermore, they would have realised that the only way forward would have been through a gradual devaluation of their currencies which, whilst making individuals, poorer, would have helped their manufacturing industries remain more competitive, and thereby slow the exodus of industry overseas. It would have been a painful adjustment, but it would have retained capital within the western economies, slowed the competitive growth of China, and would have allowed a relatively painless adjustment.

Instead, what has happened is that the adjustment is now happening. Huge sections of industry have already disappeared overseas, currencies are falling in an uncontrolled way, and so forth.

Now, as Western currencies fall, there is great potential for the Western economies to once again become competitive with the the Chinese and other emerging economies. The West is getting poorer with the drop of the currency, but that was always going to be a necessary adjustment. The cost of labour was always going to have to go through a process of equalisation. The problem now arises that the adjustment is happening at a time when the capital cupboard is bare. The banks are stricken, and government has already stretched credit to breaking point. The result of this is that, if capital is to be raised, it needs to come from the East.

I hope that, at this point, the light is coming on. The situation as it now exists is that the Western economies can only regain their competitiveness based upon finance from the East. This means that large sections of the Western economies are now going to be owned by the East. Either that, or any prospects for recovery will be very, very slow indeed.

Furthermore, it will become apparent that many of the things that we have taken for granted in the West will become unaffordable, such as bloated government and welfare states. Quite simply, if we are to compete with the East, we must either be adding significantly more value than the East can manage, or we need to have at least a comparable cost structure. The latter option looks more realistic.

As I have said, this is a very quick review and is short on facts and figures. However, the principles are very clear, and I believe rational. The current crisis is therefore a rebalancing of the world economy and, unless the West responds to the reality, the problems will persist, if not get worse. We have had very little competition and took 'top dog' status as a natural course of affairs.

2 comments:

"...the only way forward would have been through a gradual devaluation of their currencies which, whilst making individuals, poorer, would have helped their manufacturing industries remain more competitive, and thereby slow the exodus of industry overseas. It would have been a painful adjustment, but it would have retained capital within the western economies, slowed the competitive growth of China, and would have allowed a relatively painless adjustment."

Hi

One thing I don't quite understand is that you imply that China's debut in the world economy was always bound to make the West poorer. This makes me wonder why it was in our interests to trade with them in the first place. From what you say, if we had simply made a decision to ignore China we could have carried on living in the way to which we had become accustomed. I suppose this is basically protectionism, and I am sure there are sound reasons why it wouldn't work, but it is a reasonable conclusion to draw from your piece..?

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